Friday, August 15, 2008

UK import prices rising rapidly

How did the Bank of England keep the CPI inflation rate comparatively low while simultaneously allowing the money supply to increase at double digit rates?

It was a trick in three parts. First, the measurement of the CPI tended to under-estimate the true level of inflation. For example, the CPI excluded housing costs. In contrast, the older and more reliable measure - the retail price index has been flashing a four percent plus inflation rate for at least three years.

Second, middle income countries, such as India and China, have been producing lots of cheap goods. For example, clothing prices have fallen by around 50 percent since 1998. This kept prices temporarily low.

Third, sterling appreciated significantly, putting downward pressure on import prices. As the chart above illustrates, there have been periods when import price inflation was actually negative. This appreciation also moderated higher oil prices. Even allowing for fuel prices, during the last four or so years, import price inflation rarely went above 4 percent and again, there were lengthy periods when the price index including fuel was negative.

However, in the last year, import prices have turned nasty. The index including fuel is now rising at 10 percent a year, when the index excluding fuel is rising at over seven percent. Both indices have built up a lot of upward momentum.

Over the last 12 months, sterling has weakened considerably. It has fallen sharply against the euro and it is beginning to slide against the dollar. The weakening exchange rate only serves to amplify import inflation.

There is an answer to this problem. Yes, you guessed it. Raise interest rates and stabilize the value of sterling.

Relative to the rest of the world, UK labour and goods are expensive; so we need devaluation to reduce the trade deficit. Furthermore, we need inflation to help liquidate the debt mountain.

Higher interest rates mean less competitive exports (via a higher pound), hence higher unemployment and a higher trade deficit - unless such a severe recession is induced that demand actually drops. Even in that case, we'd still be wiping out manifacturing and so repeat the cycle. And, of course, we'd have the huge debt millstone stopping any consumer recovery.